What is opportunity cost?
Opportunity cost is the cost
associated with choosing one course of action over an
alternative forgone course or courses of action. There is always
a hidden cost associated with doing something that is by
definition mutually exclusive with an alternative.
Opportunity cost can be
calculated for virtually anything, albeit some scenarios are
easier to weigh against each other than others, especially if
the opportunity cost expressed is monetary.
Opportunity cost
An example would be a student
going to a university. The opportunity cost of this particular
decision is defined by the amount of money he could have earned
if he spent the time that it took him to get a degree working a
job plus the tuition fees.
So if he could have earned
$20,000 a year working and it took him 3 years to get his degree
and $30,000 in tuition fees, then the opportunity cost of
choosing to go to university, for him personally, would be
$20,000 x 3 + $30,000 = $90,000. Of course this opportunity cost
is offset by the notion that with his university degree he can
now attain a higher yearly salary.
Although opportunity cost is not
directly mentioned in accounting, it is still a very real cost
that companies take heed of. When a particular action is not
directly attached to a monetary cost, it can create the illusion
that its benefits are not associated with any costs at all –
which is of course a fallacy and that is why opportunity costs
are often referred to as hidden costs.
Many companies often use
opportunity cost, as well as other more complicated methods,
when determining the viability of a particular investment.
Opportunity cost also plays a significant role in a company’s
decision-making process. For example when developing their own
internal policy, many different companies weigh the different
options and policies against each other using opportunity cost
in order to find the one that has the smallest opportunity cost,
making it the most suitable for them.
The idea of opportunity cost also
plays an important role in economics as a whole. The study of
economics in its basic form looks at the question of how can
limited resources be used to satisfy unlimited wants. With the
help of opportunity cost, limited resources can be used more
efficiently in this regard.
This must however be taken with a
grain of salt, because on a macroeconomic level the theory of
opportunity cost becomes less relevant when production
possibility frontiers come into play. Meaning, on a
macroeconomic level it is often more efficient to produce a
mixture of several products rather than to focus on a single
one.
Even so, the theory of
opportunity cost remains a solid and widely used concept in many
of today’s aspects.
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